Biotechs and small caps outperform

Biotechs and small caps are the top performers on Wall Street, with the health-care subsector up about 8 percent for the week and the Russell 2000 hitting new highs.

Investors are expected to continue pouring money into biotechs and small caps because the sectors are insulated from the impact of the rising dollar.

“We have priced in bad news of the stronger dollar, but we haven’t priced in the good news of the stronger dollar,” said Art Hogan, chief market strategist at Wunderlich Securities.

The iShares Nasdaq Biotechnology ETF (IBB) is up 20 percent so far this year. Of the 150 stocks in the IBB, nearly half, or 64, of the names have more than doubled from their 52-week lows. Seventeen of the names (11 percent) are up more than 50 percent, while just 28 (19 percent) are lower year-to-date.

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With the Nasdaq, led by biotechs, outperforming the other major indices on Thursday, Hogan said, “there is some selectivity going on. This is a stock pickers’ market. The negative impact of the strong dollar (is not affecting) the S&P small-caps and the Russell 2000.”

It’s a “very domestically focused strong dollar play,” he said.

Companies with smaller market capitalizations, such as the average $1.3 billion for Russell 2000 names, tend to focus their business on the United States and aren’t easily impacted by fluctuations in the dollar. Lowered costs from relatively cheaper imports also help domestically oriented firms.

Blue chips or S&P 500 companies have market caps in the tens or hundreds of billions and often operate around the world.

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The Russell 2000 extended gains on Friday, trading above Thursday’s record close. The small-cap index began rallying after the Fed’s dovish statement on Wednesday afternoon. The S&P mid-caps also hit a new high.

Analysts said the rally will likely continue and could extend this historical bull market.

“The Russell 2000 breakout supports follow-through of the small caps,” said Katie Stockton, chief technical strategist at BTIG. “You can get near-time to 3 percent higher.”

The S&P 500 faces “just minor resistance” at 2,120 and can also turn higher as market participation increases and the VIX holds lower, Stockton said.

Within the small caps, biotechnology stocks are the leaders. The subsector helped the Nasdaq hold higher on Thursday while the other major indices underperformed.

Biotechnology firms, which include pharmaceuticals, are also very U.S. focused.

Fundamentals also drive biotech performance. IBB leader Biogen surged on Friday after its Alzheimer’s drug exceeded already high expectations. Celgene said earlier this year that it expected strong sales of its cancer treatment drugs, while Gilead Sciences benefits from its hepatitis C drug. Regeneron, best known for its eye drug Eylea, surged this week to hit new 52-week highs.

To be sure, the strong dollar does not mean all companies targeting the United States will perform well.

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“We have two conflicting trends. Yes, small caps have greater domestic exposure … but they trade at high valuations,” said Brian Fenske, head of sales trading at ITG.

Small caps and biotechs have some of the highest price-earnings multiples, above 20 times earnings. However, biotechs are up 40 percent in the last 12 months as the top performer in the S&P 500.

The equity play on currencies will likely hold as most analysts see continued upside in the U.S. dollar, which is up about 10 percent for the year.

“Anticipated trends among major currencies in the global foreign exchange market should proceed to move decidedly to the advantage of the U.S. unit at the expense of the euro and U.K. pound in the months immediately ahead,” John Krey, international investment analyst at S&P Capital IQ, in a Friday note.

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While anything currency-related has its risks—just think back to the depegging of the franc to the euro—FX headwinds can help investors weed out poor investments.

“It’s a testament to a good management team,” said ITG’s Fenske of firms that are able to shake off the impact of the strong dollar.

While many companies attributed weak fourth-quarter results and lowered full-year guidance to currency challenges, some firms such as Apple fared well.

“We focus on the DNA of a company and whether they’re looking towards growth,” said Tom Staudt, associate portfolio manager at ARK Investment Management. It’s a “good time to look at these growth rates and those companies that are investing (in those opportunities).”

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